3. The Australian Financial System
The Australian financial system remains in good expected to persist as banks raise more capital condition, with banks’ resilience to adverse to comply with revised regulatory standards. shocks having increased over recent years. Banks’ The downward pressure on ROE may create an capital ratios are above regulatory minimums incentive for banks to take on additional risk to and those of most international peers (when protect returns. A key element of preventing this measured on a comparable basis). Capital is to ensure that banks retain sound risk culture generation is being supported by high levels of and governance frameworks. The industry has aggregate profit, though there has been little announced a number of initiatives to improve its growth in profit over the past couple of years. risk culture and regulators have increased their Banks’ assets also continue to perform strongly; focus on bank culture and risk governance. the charge for bad and doubtful debts remains Risks within the non-bank financial sector also low and non-performing assets have stabilised appear manageable. General insurers’ profits over the past six months, after increasing a little increased in the second half of 2016, underpinned in the first half of 2016. by an improvement in underwriting results as Overall credit growth has been broadly stable commercial premium rates increased following over the past six months, but the composition of an extended period of underpricing and net this growth has changed, with investor housing claim costs declined. (The cost of Cyclone credit growth increasing. Foreign bank lending Debbie is yet to be fully determined.) In contrast, – which tends to be more cyclical than lending life insurers’ profits fell because of rising claims by local banks – has continued to grow at a rapid that compounded long-standing deficiencies pace, with growth concentrated in infrastructure in pricing, provisioning and claims processes and commercial property loans. This has partly for individual disability income insurance. offset a further reduction in lending by Australian Lenders mortgage insurers also face ongoing banks for higher‑density residential development challenges due to declining demand as banks and to the resource‑related sector. tighten mortgage lending standards. Nonetheless, The Australian Prudential Regulation Authority insurers in all three segments maintain capital (APRA) will provide more guidance over ratios that are well in excess of their regulatory coming months about what capital standards it minimums and so appear well placed to manage considers are necessary to ensure that Australian these challenges. The shadow banking sector banks are ‘unquestionably strong’. Banks have continues to pose only limited risk to financial also been working to strengthen their resilience stability due to its small share of financial system to liquidity shocks. assets to date and minimal linkages to the regulated sector. Similarly, risks stemming from The increase in banks’ capital over recent years the superannuation sector remain low due to the has lowered their return on equity (ROE). This is limited use of leverage.
FINANCIAL STABILITY REVIEW | APRIL 2017 33 Banks’ Domestic Asset Graph 3.1 Banks’ Non-performing Assets Performance Domestic books % % Australian banks’ domestic asset performance Share of all loans Share of loans by type*
was little changed over the second half of 2016 4 4 (Graph 3.1). This followed a slight deterioration Business** (35%) in asset performance earlier in 2016, especially 3 3 in Western Australia where economic conditions
have been generally weak and housing prices 2 2 Total and rents have declined. Personal (4%) Indicators of banks’ asset performance have 1 1 Housing continued to diverge across the country. Liaison (60%) 0 0 with banks suggests that the performance 2006 2011 2016 2006 2011 2016 of housing loans in mining-exposed regions * Each category’s share of total domestic lending at December 2016 is shown in parentheses; shares may not add up to 100 due to rounding may have stabilised towards the end of 2016. ** Includes lending to financial businesses, bills, debt securities and other non-household loans However, data on securitised housing loans Sources: APRA; RBA suggest that delinquencies edged up further in Western Australia in early 2017 and remained Graph 3.2 Securitised Mortgage Arrears Rates* higher in states with larger exposures to the Balance-weighted share of loans 90+ days in arrears mining sector, where economic conditions have % % been relatively weak (Graph 3.2). The majority WA 0.8 0.8 of banks’ non-performing housing loans remain SA well secured, with the impaired share very low.1 In Qld 0.6 0.6 addition, stress testing conducted by APRA in Tas 2014 indicated that housing prices would have 0.4 0.4 to fall significantly before banks incurred sizeable Vic losses.2 In liaison, banks report that business loan 0.2 0.2 arrears had continued to drift up in the states with NSW
large mining sectors, but that the low interest rate 0.0 0.0 environment is supporting asset performance. S D M J S D M J 2016 Future asset performance will continue to * Measured at trust report dates Sources: ABS; RBA be influenced by conditions in real estate markets and the resources sector, as well as basis. Nonetheless, if apartment markets in macroeconomic conditions more generally. The some cities were to turn down and settlement strengthening of housing lending standards difficulties became widespread, banks could over the past couple of years is also expected to incur some losses, particularly on their property support future loan performance on an ongoing development lending.3
1 Impaired loans are those that are not well secured and there are doubts as to whether the full amounts due will be obtained in a timely 3 Previous work has shown that, if apartment conditions were to manner. Past-due loans are at least 90 days in arrears, but well secured. deteriorate in inner-city areas, banks would be more likely to 2 For further details, see Byres W (2014), ‘Seeking Strength in Adversity: experience material losses on their development lending than Lessons from APRA’s 2014 Stress Test on Australia’s Largest Banks’, on their mortgages. For further details, see RBA (Reserve Bank of Speech at the AB+F Randstad Leaders Lecture Series, Sydney, Australia) (2016), ‘Box B: Banks’ Exposures to Inner-city Apartment 7 November. Markets’, Financial Stability Review, October, pp 25–28.
34 RESERVE BANK OF AUSTRALIA Credit Conditions banks have also stopped accepting refinancing applications from new customers on some Overall domestic credit growth has moderated investment property loans and have moved to over the past two months after increasing in late limit negative gearing benefits when assessing 2016, mainly reflecting developments in business serviceability. The most recent round of banks’ credit (Graph 3.3). interest rate rises for investor loans may dampen Graph 3.3 investor demand in coming months. Credit Growth Six-month-ended annualised Credit conditions in the business sector have % % Housing Business been broadly stable over the past six months, although a few lenders have reported 20 20 further tightening in financing conditions for residential development, particularly for Investor 10 10 projects in geographic areas considered at risk Household of deteriorating housing market conditions and
Total Owner-occupier localised oversupply. Business credit growth has 0 0 moderated, following strong growth in late 2016 driven by a few large infrastructure privatisation
-10 -10 deals. Outside of these deals, the underlying 2007 2012 2017 2007 2012 2017 pace of business credit growth slowed over most Sources: APRA; RBA of 2016, although business credit to small and After falling back following the measures medium enterprises is growing at its fastest pace announced by APRA at end 2014, investor since 2009. Banks have further reduced their housing credit growth has increased noticeably direct exposures to the resources sector. since the previous Review, and is now above Lending by foreign-owned banks operating the rate for owner-occupier housing credit in in Australia has continued to increase, with six-month-ended annualised terms. In liaison, lending by banks headquartered in Asia banks attributed the pick-up in investor credit accounting for almost all of this growth. Asian growth both to strong underlying demand and banks now supply around 11 per cent of the to investors and brokers developing a better stock of business credit in Australia, up from understanding over time of how to comply with around 6 per cent in 2012. Their increased the changes to lending standards introduced lending has been spread across industries, most from late 2014. Of late, the monthly growth rate notably infrastructure and commercial property of investor housing credit has slowed a little, (Graph 3.4). While foreign banks have long been in line with a slight decline in investor loan active in providing such specialised lending, their approvals over the past few months. As noted activity in Australia has historically been highly in the previous chapter, a number of banks have pro-cyclical and has tended to exacerbate asset raised interest rates on investor and interest-only price and economic cycles. (IO) loans over recent months – in part to stay within the 10 per cent investor growth threshold set by APRA – and some banks have further tightened housing lending standards. A few
FINANCIAL STABILITY REVIEW | APRIL 2017 35 Graph 3.4 Graph 3.5 Asian Banks’ Business Lending Australian-owned Banks’ International Exposures Share of total business credit Share of assets, ultimate risk basis % % % % Lending to non-bank Exposures to other sectors private sector* 8 8 6 6 NZ
Other Public sector** (incl. infrastructure) 6 6 Other countries 4 4 4 4 Construction Wholesale Manufacturing trade Banks 2 2 2 2 Mining Commercial property* 0 0 0 0 2012 2016 2012 2016 2012 2016 2012 2016 * Commercial property exposures overlap with industry categories * Includes all exposures to non-bank private sector, comprised Sources: APRA; RBA predominantly of lending ** Predominantly sovereign bonds held outright or on repo and central bank deposits International Exposures Sources: APRA; RBA Australian-owned banks have reduced their Graph 3.6 international exposures over the past year. International Lending by Region Lending to non-bank private sector, excluding New Zealand* Reduced lending in the United Kingdom and Asia % % more than offset rising exposures to New Zealand UK 2.5 2.5 and a trend increase in Australian-owned
banks’ holdings of liquid foreign assets, such 2.0 2.0 as sovereign bonds and central bank deposits Asia 1.5 1.5 (Graph 3.5; Graph 3.6). Most prominently, NAB US sold its UK subsidiary in early 2016 and ANZ 1.0 1.0 continued to reduce its exposures to institutional Other lending and trade finance activities in Asia. 0.5 0.5 Exposures to Asia are expected to decline further Europe 0.0 0.0 over the coming year as ANZ completes the 2010 2011 2012 2013 2014 2015 2016 * Australian-owned banks; share of assets, ultimate risk basis; exposures sale of several of its retail banking and wealth to non-bank private sector, comprised predominantly of lending management businesses in the region. Sources: APRA; RBA
In contrast, Australian-owned banks’ lending in of household debt increases the risks to New Zealand has continued to grow quickly. these exposures and has prompted a further Given low unemployment, the performance of tightening of New Zealand’s macroprudential the major banks’ New Zealand housing portfolios requirements. While Australian banks’ exposures has remained strong to date; mortgage arrears to the New Zealand dairy sector remain under are around their lowest levels in at least a watch, the immediate risks have receded over decade. However, as discussed in ‘The Global the past six months given higher milk prices Financial Environment’ chapter, the combination and ongoing reductions in producers’ operating of rapid housing price growth and high levels costs. Provisions held against dairy loans have not increased further.
36 RESERVE BANK OF AUSTRALIA Liquidity and Funding yields (Graph 3.8). Nonetheless, most Australian banks are on outlook for downgrade by the Australian banks have continued to build major credit rating agencies, which cite rising resilience to liquidity and funding shocks. Banks’ levels of household debt and risks to the housing aggregate holdings of high-quality liquid assets, market as key factors behind their assessments. which provide a buffer against short periods of liquidity stress, were around 130 per cent of their Conditions in securitisation markets improved projected net cash outflows as at December over the past year. Issuance in the December 2016 2016, well above the 100 per cent minimum and March 2017 quarters was high compared Liquidity Coverage Ratio (LCR) requirement. with recent years and spreads at issuance have Most banks that will be subject to the Net narrowed significantly (Graph 3.9). Despite the Stable Funding Ratio (NSFR) requirement have Graph 3.7 a ratio that is currently above 100 per cent, Banks’ Bond Issuance* following the finalisation of standards by APRA in Cumulative, A$ equivalent $b $b December. The NSFR is intended to complement Gross Net 2016 the LCR by encouraging banks to fund less liquid assets with more stable liabilities, such as 120 25 long-term debt and retail deposits, and is due to 2010–16 average come into effect from the start of 2018. 80 0 2017** Looking ahead, banks are likely to further increase their NSFRs to provide a suitable buffer 40 -25 above the regulatory minimum. This will most likely be achieved by raising additional long-term 0 -50 wholesale funding, though 2017 issuance J F M A M J J A S O N D J F M A M J J A S O N D may not surpass last year’s strong outcome * Shaded area is the range for 2010–16 ** April is month-to-date (Graph 3.7). Retail term deposits are also a stable Source: RBA source of funding that support banks’ NSFRs. Graph 3.8 Competition for these deposits remains high, Banks’ Debt Pricing but has eased recently as banks’ NSFRs have Spread to swap bps bps risen and because extending the term of these Short term* Long term** deposits does only a little to increase the NSFR. In comparison, extending the term of wholesale 75 150 deposits, such as those for superannuation funds and businesses, has a greater positive effect on 50 100 banks’ NSFRs. This has prompted some banks to introduce wholesale deposit products that offer more stability to their funding mix. 25 50 Wholesale funding market conditions have remained very favourable over the past year. 0 0 2009 2013 2017 2009 2013 2017 Spreads on banks’ short-term and long-term * Three-month bank bill swap to three-month overnight indexed swap ** Major banks’ three-to-five-year A$ bonds on a residual maturity basis wholesale funding have declined despite a range to four-year interest rate swap Sources: AFMA; Bloomberg; Tullett Prebon (Australia); UBS AG, Australia of risk events in 2016 and the rise in global bond Branch
FINANCIAL STABILITY REVIEW | APRIL 2017 37 Graph 3.9 minimum requirements. The major banks Australian Asset-backed Securities retain a buffer of around 1½ percentage points $b Issuance, quarterly $b ADI RMBS Non-ADI RMBS Other asset-backed above the 8 per cent Common Equity Tier 1 30 30 (CET1) threshold, which includes the 4½ per 20 20 cent minimum in the prudential standard and a 10 10 3½ per cent capital conservation buffer (of which 1 percentage point is the add-on for domestic bps RMBS primary market pricing, monthly* bps 150 150 systemically important banks; Graph 3.10). The countercyclical capital buffer, which can be 100 100 used to raise capital requirements in periods of 50 50 rising systemic risk, remains at zero per cent. 0 0 2005 2008 2011 2014 2017 Graph 3.10 * Bank conforming deals; face value weighted monthly average of the primary market spread to bank bill swap rate for AAA-rated notes Major Banks’ CET1 Capital Ratios Source: RBA APRA Basel III basis, December 2016 Regulatory recent improvement, activity in securitisation requirement markets remains well below pre-crisis levels and this source of funding accounts for less than ANZ 2 per cent of banks’ total funding. In November 2016, APRA finalised its revised CBA securitisation framework, with the new rules to apply from January 2018.4 The revised NAB framework aims to make securitisation a more viable funding source by offering issuers Westpac more flexibility and clarity around transaction 0 2 4 6 8 10 % structures. This includes a greater ability to issue CET1 Minimum Capital conservation buffer D-SIB add-on
bullet maturity securities (which appeal to a wider Sources: APRA; Banks’ financial disclosures; RBA range of investors) and clarity around classifying transactions as either for funding-only or capital As was expected, the implementation in relief purposes (with issuers having the ability to July 2016 of APRA’s decision to increase risk switch qualifying transactions to capital relief after weights on mortgages for banks that use internal issuance). The revised framework also implements models to assess credit risk lowered the major Basel lll reforms, which generally require banks to banks’ CET1 capital ratios by just under 80 basis hold more capital against asset-backed securities. points (Graph 3.11). This offset part of the capital that the banks had raised earlier in anticipation Capital and Profitability of this and other changes. In the absence of this change, the major banks’ CET1 ratios would Australian banks’ resilience is supported by have increased a little over the past six months, capital levels that are significantly above with capital accumulation outpacing growth in 4 APRA Prudential Standard, APS 120 Securitisation. Available at risk-weighted assets.
38 RESERVE BANK OF AUSTRALIA Graph 3.11 3 per cent minimum due to be introduced in Major Banks’ Capital Ratios* 2018. The leverage ratio is a non-risk-based Consolidated global operations % % measure of a bank’s Tier 1 capital relative to its total exposures, and is intended to be a backstop 11 11 Tier 1 capital ratio to the risk-based capital requirements. 9 9 APRA will provide further guidance in coming CET1 capital ratio 7 7 months on what capital standards it believes Leverage ratio** 5 5 are necessary to make banks ‘unquestionably strong’. It has reiterated that revisions to the capital % Average risk weight*** % framework will be guided by a range of factors, 50 50 including the recommendation in the Financial System Inquiry that CET1 capital ratios should be 25 25 2004 2007 2010 2013 2016 in the top quartile of international peers, stress test * Dots are estimates of capital ratios in the absence of higher mortgage risk weights; break in March 2008 due to the introduction of Basel II; results, rating agency measures and allowing for break in March 2013 due to the introduction of Basel III ** Estimated prior to September 2015 as Tier 1 capital as a per cent flexibility throughout the economic cycle. It will of assets *** Risk-weighted assets as a per cent of assets also consider banks’ broader risk profiles, including Sources: APRA; RBA funding and liquidity, earnings and governance. As part of this process, APRA will review whether Graph 3.12 Banks’ Capital Ratios* and how to adjust risk weights on mortgages. Consolidated global operations % % It is likely that Australian banks will need to increase their capital ratios over coming years to Total comply with APRA’s framework for ‘unquestionably 12 12 strong’ standards. APRA expects that banks will be able to manage any increase in capital CET1 8 8 requirements with appropriate capital planning. Tier 1 Banks’ high levels of profits continue to support
4 4 retained earnings. In addition, risk-weighted asset Tier 2 growth (which subtracts from banks’ capital ratios) has been subdued over the past year as banks 0 0 1991 1996 2001 2006 2011 2016 have pulled back from less profitable institutional * Per cent of risk-weighted assets; break in March 2008 due to the exposures with higher risk weights, but there introduction of Basel II; break in March 2013 due to the introduction of Basel III are limits to banks’ ability to continue improving Source: APRA capital ratios by shedding riskier assets. negative effect of higher mortgage risk weights Australian banks continue to generate significant was partly offset by an increase in non-common levels of profit, but aggregate profit in the most equity capital. Unlike in the first half of 2016, this recent half year was only slightly higher than issuance did not coincide with large maturities a couple of years ago (Graph 3.13). The lack or regulatory deductions, and so resulted in a net of profit growth is partly explained by lower increase in non-common equity capital. non-interest income as wealth management The major banks’ aggregate leverage ratio and life insurance income has declined and increased a little over the second half of 2016 to banks have booked unrealised losses on some 5.1 per cent and remains well above the planned assets. Net interest income has also grown only
FINANCIAL STABILITY REVIEW | APRIL 2017 39 Graph 3.13 Graph 3.14 Banks’ Profits Banks’ Profitability $b Net profit after tax $b index Income and capital index 2011/12 year average = 100 18 18 140 140 After one-offs Total regulatory capital 12 12 Total income 100 100 6 6
% % 2006 Charge2008 for2010 bad and doubtful2012 debts2014 2016 % Return on equity % Per cent of average assets 0.3 0.3 16 16 0.2 0.2 12 12 0.1 0.1
0.0 0.0 8 8 2006 2008 2010 2012 2014 2016 2006 2008 2010 2012 2014 2016 Sources: APRA; RBA Sources: APRA; RBA
modestly as asset growth has slowed and the net have been much more moderate, resulting interest margin has narrowed. The charge for bad in banks’ forward earnings yields declining and doubtful debts remains around historically (particularly compared with the broader market; low levels but stopped falling – and supporting Graph 3.15).5 However, banks’ earnings yields profit growth – in 2014. Analysts expect bank are still similar to the levels prevailing pre-crisis, profit growth to pick up a little over coming despite a large decline in risk-free rates. years, supported by forecast stronger asset growth and a recovery in non-interest income. Graph 3.15 Forward Earnings Yields Analysts also expect the charge for bad and % % doubtful debts to remain low as a share of assets after deteriorating in the first half of 2016. 12 12 ASX 200 Banks The rise in bank capital over the past two years, 10 10 combined with minimal profit growth, has reduced banks’ ROE below its historical average 8 8 of 15 per cent (Graph 3.14). Lower ROE seems likely to persist as banks accumulate more capital 6 6 to meet an ‘unquestionably strong’ standard. ASX 200 (excl. banks) So far banks have mainly responded to lower ROE 4 4 by repricing their loans and selling lower-return 2005 2008 2011 2014 2017 wealth management and international assets. Sources: RBA; Thomson Reuters Westpac also recently lowered its ROE target. Bank Culture However, it is possible that Australian banks may attempt to restore their ROE to historical levels by A key to preventing excessive risk-taking by taking on additional risk in ways that are not fully banks is to ensure that they maintain sound captured by regulatory risk weights. 5 The forward earnings yield is a measure of banks’ cost of equity – Bank share prices have risen strongly over the return that is required to entice investors to purchase and hold the past six months, in line with global bank shares. See Norman D (2017), ‘Returns on Equity, Cost of Equity and the Implications for Banks’, RBA Bulletin, March, pp 51–58 for trends. Increases to analysts’ earnings forecasts more detail.
40 RESERVE BANK OF AUSTRALIA risk culture and governance frameworks. Shadow Banking International experience has shown that banks The tighter post-crisis prudential framework that allow or encourage a culture of excessive for the regular banking system creates a risk risk-taking can pose significant harm to financial that credit provision will migrate to the less stability if poor culture becomes pervasive. This regulated shadow banking sector. However, can result in credit being extended to customers there is estimated to have been little growth that cannot service it or misconduct charges in shadow banking activity over the past two against banks that erode their capital. years (Graph 3.16). The size of the shadow In Australia, there have been some recent banking system is still small, at around 6 per examples of poor conduct within the banking cent of financial system assets compared with industry. The most prominent of these have over 10 per cent in 2007, and is considerably arisen in banks’ life insurance and wealth smaller than in a number of large economies. management subsidiaries. More generally, APRA’s Systemic risks to the financial system are also observation is that in some cases banks allowed limited by the small linkages shadow banks have a culture to develop within their core banking with the prudentially regulated financial sector, divisions over recent years that prioritised with banks’ exposures to the sector only around protecting market share in mortgage origination 4 per cent of total financial assets. over sound lending practices.6 Securitisation is one area of the domestic The banking industry has announced initiatives shadow banking sector that continues to warrant to improve culture in the financial services particular attention, given that prudentially sector. These include steps to improve consumer regulated entities have tightened their lending protection, address inappropriate remuneration standards in recent years and mortgage incentives and strengthen risk management frameworks. APRA has also increased its focus on Graph 3.16 the risk culture of the institutions it regulates to Shadow Banking in Australia Financial assets, by economic function* $b % ensure that banks’ efforts in this area are lasting, Value Share of financial system** while the Australian Securities and Investments Commission has been vigilant in identifying poor practices. APRA’s efforts focus on two areas: 500 10 requiring the boards of each bank to form a view on the risk culture within their institution and the extent to which that culture encourages it 250 5 to operate within its risk appetite; and requiring the boards of each bank to identify desirable changes to risk culture and ensure steps are 0 0 taken to address these.7 2006 2011 2016 2006 2011 2016 Hedge funds*** Other funds investing in credit products Non-prudentially consolidated finance companies Securitisation vehicles (excluding self-securitisation) * Total assets for some entity types where financial assets data are 6 APRA (2016), ‘Risk Culture’, Information Paper, October. unavailable ** Financial system excludes the RBA 7 APRA, Prudential Standard CPS 220 Risk Management. Available at *** Hedge fund data are only available from June 2008
FINANCIAL STABILITY REVIEW | APRIL 2017 41 originators tend to have somewhat riskier Graph 3.17 loan pools than banks. For example, mortgage General Insurers’ Financial Ratios Annualised originators’ residential mortgage‑backed % Contributions to return on equity % securities (RMBS) are backed by higher shares 30 30 of loans with low documentation and high 15 15 loan-to-valuation ratios. Mortgage originators’ 0 0 issuance of RMBS picked up in late 2016 as market conditions improved, but non-bank -15 -15
securitised mortgages are still only around % % 2004 2007 Net loss2010 ratio* 2013 2016 1 per cent of Australian mortgages. Mortgage 80 80 originators are in part constrained from adding 60 60 much to overall credit growth because they have 40 40 limited access to warehouse funding from banks 2004 2007 2010 2013 2016 (that is, short-term finance to the originator prior Return on equity Underwriting result Investment income Tax and other to the mortgages being securitised) and because * Ratio of net incurred claims to net premium; change in reporting basis after June 2010 they lack capacity to process large loan volumes. Sources: APRA; RBA APRA recently emphasised that it would be concerned if banks allowed their warehouse cover should limit the impact on profits. The facilities to grow materially faster than their own general insurance industry has remained well housing loan portfolios. capitalised, with capital equivalent to 1.8 times APRA’s prescribed amount. Insurance Lenders mortgage insurers (LMIs) – which General insurers’ profits increased in the support banks’ resilience by offering protection second half of 2016 after several periods of against losses on defaulted mortgages – soft underwriting results, although ROE for continue to face challenges. LMI profits declined the sector remains below its historical average sharply over the past couple of years due to a because of ongoing subdued investment decrease in high LVR lending, as banks tightened returns (Graph 3.17). The recent rise in profits mortgage lending standards, and increased was underpinned by stronger underwriting claims in Western Australia and Queensland. results, because of higher domestic commercial These headwinds seem likely to persist, given premium rates (as insurers sought to correct a APRA’s recent directive to limit the flow of new long period of underpricing) and an increase high-LVR IO loans. An additional challenge for in compulsory third-party insurance premiums. the LMI industry is to renew existing contracts Net claims also fell because of a decline in as the major banks consider whether to follow payouts for natural disasters and higher reserves Westpac’s decision in 2015 to self-insure its releases, reducing the net loss ratio (the ratio mortgages. Despite these issues, the LMI sector of net incurred claims to net premium) to its remains well capitalised at 1.5 times APRA’s lowest level in several years. This follows a decade prescribed amount. in which natural disaster claims consistently Challenges in the life insurance industry have exceeded provisions. Payouts for natural disasters increased further, though the sector also remains may rise again in 2017 because of Cyclone well capitalised, with capital equivalent to Debbie, but existing provisions and reinsurance 1.8 times APRA’s prescribed amount. Life insurers’
42 RESERVE BANK OF AUSTRALIA profits fell markedly in 2016 and overall ROE the managed fund sector (a higher share than dropped to its lowest level since the financial in other advanced economies) and equivalent crisis (Graph 3.18). The recent weakness in life to around half the size of the Australian banking insurers’ profits was driven largely by a fall in system. Total superannuation assets grew by individual total and permanent disability profits 7 per cent in 2016, around the post-crisis average and ongoing losses on individual disability rate, supported by stronger investment returns income insurance (commonly known as as global share markets rallied (Graph 3.19). ‘income protection insurance’). Underlying this The financial stability risks inherent in the deterioration has been an increase in claims superannuation industry are lower than for that insurers now assess to be permanent, other parts of the financial system because debt compounded by long-standing deficiencies funding accounts for a very small share of its total in pricing, provisioning and claims processes. liabilities (particularly for APRA-regulated funds). These structural weaknesses were highlighted However, APRA-regulated superannuation funds last year by APRA in its stress tests on domestic face increased liquidity risks as the ageing of life insurers and form some of the matters being Australia’s population results in a trend increase considered by the parliamentary inquiry into the in members entering the drawdown phase, life insurance industry that was announced in or as members roll funds into self-managed September 2016. superannuation funds.
Graph 3.18 Graph 3.19 Contributions to Life Insurers’ Profitability Superannuation Funds’ Flows* Annualised $b $b % % 75 75
15 15 0 0
-75 -75 10 10 Net investment income Net contribution flows** Other $b Net contributions $b 60 60 5 5 Total contributions 40 40
0 0 20 20 Benefit payments (incl. net transfers) 0 0 -5 -5 2006 2008 2010 2012 2014 2016 2010 2012 2014 2016 * APRA-regulated entities with more than four members Individual death/TPD* Non-participating investment-linked ** Total contributions received by funds plus net rollovers minus benefit Group death/TPD* Other** payments Individual disability Return on equity Sources: APRA; RBA
* TPD = total and permanent disability ** Includes profit from other non-risk business Source: APRA; RBA Financial Market Infrastructures Financial market infrastructures (FMIs) – such as Superannuation payment systems, central counterparties (CCPs) The superannuation sector remains a large and securities settlement systems – facilitate and growing part of Australia’s financial the completion of most financial transactions system. Total assets amount to over $2 trillion, in the economy. FMIs need strong regulation accounting for three-quarters of the assets in and supervision because they concentrate both services and risk as a result of their activities.
FINANCIAL STABILITY REVIEW | APRIL 2017 43 FMIs operating in Australia have continued to in advance of the measures being used to ensure function smoothly over the past six months. that participants were adequately prepared for The Reserve Bank Information and Transfer the additional margin calls. The additional margin System (RITS) – which is used by financial calls enabled by the changes – particularly institutions to settle payments – processed those conducted late in the Australian trading around 6 million transactions in the six months day – provided additional protection against to March, with an aggregate value of $22 trillion. the risks associated with potentially elevated There were no major RITS operational incidents volatility during the overnight session, during this period and the frequency and when adhoc margin calls are currently not duration of members’ operational incidents operationally possible. remained at historical lows. For CCPs, a major test Additional work is underway to further enhance was during the period of heightened volatility the resilience of FMIs. In relation to RITS, the associated with the US Presidential election. Reserve Bank’s recent evaluation included a focus The ASX Group CCPs implemented a number on projects to review cyber security controls and of changes to margin requirements ahead of the system’s ability to detect and recover from the election to mitigate the risks associated operational incidents. This exercise concluded with potentially elevated market volatility. that security controls were generally very strong. These included maintaining margin rates at Nonetheless, a number of recommendations the elevated level in the period following the were made for further improvements, some of UK referendum and reducing intraday exposure which have already been implemented while limits. ASX communicated to market participants others are in progress. R
44 RESERVE BANK OF AUSTRALIA